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FXI’s Not The Best China ETF

Matt Hougan, our president of ETF Analytics, was on CNBC's Fast
Money recently and talked about the pitfalls of the iShares FTSE
China 25 Index Fund (NYSEArca:FXI) and why other funds like the
SPDR S&P China ETF (NYSEArca:GXC) might be a better choice for
those looking for broad China exposure.

I'll pick up where Matt left off to examine in detail the
various China ETFs, and why some funds make more sense than others,
as there are big differences between them.

When I consider a China ETF, the first thing I check for is what
type of shares the ETF is eligible to hold.

As most of us are aware, foreign investment in China is still
restricted, and with the exception of a select few qualified
foreign institutional investors (QFII), investing in 'A-shares' is
for the most part off the table.

Therefore, the current ETFs access the Chinese market through a
combination of H-shares, Red Chips, P-chips, B-shares or N-shares.
Let's call all these shares 'investable' Chinese shares.

Let's look at the table below, because there are many different
share classes, and grasping their differences is crucial.

Share Type

Description

A-shares

Chinese companies incorporated in the mainland and traded
in Shanghai or Shenzhen in RMB

H-shares

Chinese companies incorporated in the mainland and traded
in Hong Kong

Chinese companies traded in the U.S. (sometimes ADRs of
H-shares and Red Chips are also
referred to as N-shares)

B-shares

Chinese companies incorporated in mainland traded in
Shanghai in USD or Shenzhen in HKD (open to foreign
ownership)

Note:Some companies float different share classes on
different exchanges.

Interestingly, many popular China ETFs aren't eligible to hold
all investable shares, making their China exposure limited in
scope.

If you want the broadest, most inclusive exposure to China,
wouldn't you want an ETF that's eligible to hold all these
investable shares?

FXI is by far the most popular China ETF. As I said at the
outset, it has $4.8 billion in assets, and it trades over $600
million a day at pennywide spreads. For an institution whose
primary concern is liquidity, FXI is a no-brainer.

But for most of us looking to invest in total China, FXI has
some serious shortcomings.

Apart from only holding 25 of the largest Chinese companies
traded in Hong Kong, I can't help but notice that mega-cap Tencent
Holdings is missing from its portfolio.

Tencent Holdings is China's largest Internet company, with a
market capitalization of $53.7 billion. Its instant-messenger site,
QQ.com, has over 700 million users and, according to Alexa.com,
it's the second-most-visited site in China.

Still, it's missing from FXI's holdings. Why?

FXI is only eligible to hold H-shares and Red Chips. Tencent is
incorporated in the Cayman Islands, so even if it's Hong
Kong-listed, it's classified as a P-chip, so it's not eligible for
inclusion.

I should note here that while FXI's underlying index provider,
FTSE, currently assigns P-chips to Hong Kong, only a few weeks ago
it announced the reclassification of P-chips from Hong Kong to
mainland China. That change is set to become effective in March
2013. That could mean the holdings of FXI may change sometime next
year.

In the meantime, FXI is basically a mega-cap play on China's
state-owned telecoms, energy and financial companies. China's 'big
four' state-owned banks-China Construction Bank, ICBC, Bank of
China and Agricultural Bank of China-make up over a quarter of the
fund's weighting. No thanks.

As Matt suggested on CNBC, GXC is a broader fund that not only
holds 180 positions, it's also eligible to hold all investable
Chinese shares. Another fund with a similar scope is the Guggenheim
China All-Cap Fund (NYSEArca:YAO).

While both GXC and YAO are still top-heavy in many of the same
mega-cap names as FXI, investors will also find P-chip names like
Tencent and Want Want China, as well as N-shares like Baidu, Sina
and NetEase among their holdings.

Baidu is China's largest search engine-basically the Google of
China. Sina, on the other hand, not only operates the largest Web
portal in China, it runs the micro-blogging site Weibo, which is
China's equivalent to Twitter, which now has over 300 million
users.

If you were to buy the broadest U.S. fund, wouldn't you want
Google, Yahoo-and Twitter, if it were public-and other big tech
names included?

There's a relatively new China ETF that's now gaining in
popularity, the iShares MSCI China Index Fund (NYSEArca:MCHI). It's
already amassed over $400 million in 15 short months. I hate to
pour cold water on such a blistering run, but if you look closely,
MCHI doesn't hold any N-shares.

That's because it tracks an MSCI index, and MSCI considers a
stock's primary listing and country of incorporation as a large
component in assigning stocks to countries. Since many of these
Chinese tech names are incorporated in tax havens such as the
Cayman Islands and exclusively list in the U.S., MCHI isn't
eligible to hold them.

The iShares FTSE China Index Fund (NYSEArca:FCHI) is even more
limited in scope. It's not eligible to hold P-chips, and only holds
H-shares and Red Chips, making FCHI a broader, total market version
of FXI.

For those looking to completely get away from China's
state-owned mega-caps, two of my favorites are the Guggenheim China
Small Cap ETF (NYSEArca:HAO) and the Global X China Consumer ETF
(NYSEArca:CHIQ).

HAO is a small-cap fund with roughly half its weighting in
industrials and consumer goods, while CHIQ focuses specifically on
the China consumer space. But most importantly, both are eligible
to hold all investable Chinese shares.

The takeaway here isn't so much a bullish call on China; it's
that if you're going to invest in China for the long haul, wouldn't
you prefer to have exposure to all investable share classes?

By being all-inclusive, it opens the fund up to more exposure to
the consumer and entrepreneurial side of China. That, to me, is
where the true growth potential lies, rather than the old
state-owned behemoths that you see in FXI.

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